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economy. It is defined as the value at the final point of sale of all goods and

services produced during a given period by both domestic and foreign-owned

enterprises. GDP and changes in GDP are sometimes reported in current-year,

or nominal, dollars. In 1993, for example, current-year GDP provides a useful

measure of productive output valued at then-current prices. However,

inflation that causes economy-wide changes in the price level can distort

nominal GDP figures and create a picture of robust activity when the economy

is actually sluggish. As a result, GDP and changes in GDP are also measured in

inflation-adjusted, or real, terms. When GDP is evaluated using constant 1987

dollars, the effects of economy-wide inflation are controlled, and the pace of

real economic activity is revealed. For this reason, inflation-adjusted GDP

figures are often referred to real GDP terms. Table 1 shows current-year and

real GDP figures for the U.S. economy for the 32-year period from 1959 to

1991.

GDP data for the entire 1959-1991 period offer the basis to test the

ability of a simple constant growth model to describe the trend in GDP over

time. However, such a regression model cannot be used to forecast GDP over

any subpart of that period. To do so would be to overstate the forecast

capability of the regression model since, by definition, the regression line

minimizes the sum of squared deviations over the estimation period. To test

forecast reliability, it is necessary to test the predictive capability of a given

model over data that was not used to generate the regression model. These

data offer an interesting basis for evaluating the usefulness of the simple

growth model approach to economic forecasting. In the absence of GDP data

for the 1991-1995 period, the reliability of alternative forecast technique can

be illustrated by arbitrarily dividing historical GDP data into two subsamples:

a 1959-1983 test group, and a 1984-1991 forecast group. A regression model

estimated over the test group can be used to forecast actual GDP over the

1984-1991 period. Estimation results over the 1959-1983 subperiod provide

a forecast model that can be used to evaluate the predicitive reliability of a

constant growth model over the 1984-1991 forecast period.

Table 1. Gross Domestic Product in Current-Year (Nominal)

Dollars and in 1987 Dollars, 1959-91

Year

dollars (in billions) (in billions) (in years)

1991 5,671.8 4,848.4 33

1990 5,513.8 4,884.9 32

1989 5,244.0 4,836.9 31

1988 4,900.4 4,718.6 30

1987 4,539.9 4,540.0 29

1986 4,268.6 4,405.5 28

1985 4,038.7 4,279.8 27

1984 3,777.2 4,148.5 26

1983 3,405.0 3,906.6 25

1982 3,149.6 3,760.3 24

1981 3,030.6 3,843.1 23

1980 2,708.0 3,776.3 22

1979 2,488.6 3,796.8 21

1978 2,232.7 3,703.5 20

1977 1,974.1 3,533.2 19

1976 1,768.4 3,380.8 18

1975 1,585.9 3,221.7 17

1974 1,458.6 3,248.1 16

1973 1,349.6 3,268.6 15

1972 1,207.0 3,107.1 14

1971 1,097.2 2,965.1 13

1970 1,010.7 2,875.8 12

1969 959.5 2,877.1 11

1968 889.3 2,801.0 10

1967 814.3 2,690.3 9

1966 769.8 2,622.3 8

1965 702.7 2,473.5 7

1964 648.0 2,343.3 6

1963 603.1 2,218.0 5

1962 571.6 2,129.8 4

1961 531.8 2,025.6 3

1960 513.4 1,973.2 2

1959 494.2 1,931.3 1

A. Set up a table or spreadsheet with GDP data for the 1959-1991 period as

shown in the previous table. Transform these GDP data using natural

logarithms so that it will become possible to analyze them using a constant

growth model with continuous compounding.

B. Use the simple regression model approach to estimate, in turn, the linear

relationship between the natural logarithm of (1) nominal GDP and time,

and (2) real GDP (ln GDP) and time. Estimate each model over two time

intervals: the entire 1959-1991 period and the 1959-1983 test subperiod,

where

lnYt = b0+b1Tt+ut

and where lnYt is the natural logarithm of each respective measure of GDP

in year t, and T is a time trend variable (where T1 = 1959, T2 = 1960, T3 =

1961,…, and T25 = 1983); and u is a residual term that includes the effects

of all factors that have been omitted from the regression models and the

effects of random or stochastic elements. These are called constant growth

models because they are based on the assumption of a constant percentage

growth in economic activity per year. How well does each constant growth

model fit actual GDP data?

C. Create a spreadsheet that shows actual and forecast GDP values for the

1984-1991 period. Each GDP forecast is derived using the coefficients

estimates for each model in Part B along with values for each respective

time trend variable over the 1984-1991 period. Remember that T26 = 1984,

T27 = 1986, T28 = 1987,…, and T33 = 1991 and that each constant growth

model provides predicted, or forecast, values for the relevant lnYt variable.

To obtain values for Yt, simply take the antilog (exponent) of each

predicted lnYt variable. Place these forecast values in the spreadsheet

alongside actual figures. Then, subtract actual figures from forecast values

to obtain annual estimates of forecast error for each Yt variable, plus an

estimate of average forecast error for each Yt variable over the 1984-1991

period.

D. Compute the correlation coefficient between actual and forecast values for

each Yt variable over the 1984-1991 period. Also compute the sample

mean forecast error for each Yt variable. Based on these findings, how well

do constant growth models generated using data over the 1959-1983

period forecast actual GDP data over the 1984-1991 period?

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